Lessons from MF Global

The October bankruptcy of MF Global has been the subject of several Congressional hearings recently. 38,000 MF Global clients lost $1.2 billion in the collapse, and numerous regulators, as well as the Department of Justice, have been trying to unravel hundreds of thousands of transactions to discover how this client money disappeared. Weeks later, it’s still unknown whether clients will have their funds returned or whether any laws were broken. What is certain, though, is that even after the passage of Dodd-Frank, our regulatory system has large supervisory gaps.

The derivatives and futures businesses in which MF Global operated are complex, and it’s easiest to understand the firm as a large transaction processor that served its futures clients by connecting them to exchanges around the world. MF Global was both a broker-dealer and a futures commission merchant, meaning it was regulated by the SEC as well as the CFTC. In addition, MF Global was overseen by the Financial Industry Regulatory Authority (FINRA) and the CME, two self-regulatory organizations empowered by the SEC.

The big problem with oversight of MF Global within the U.S. is that there were too many regulators with only a small window into the firm’s activities and none with the ability to see the full scope of risks and capital of the holding company. How can we fix this?

The U.S. Chamber of Commerce recently put out a report by a long-time SEC official that recommended a number of softball procedural and structural changes for the SEC, like increasing the number of Commissioners from 5 to 7 and appointing a deputy chairman who would be responsible for operations and management. The report also recommended using cost-benefit analysis at the beginning of the rule-making process and after a rule had been implemented. It was thoughtful and well-meaning but wholly overlooked the fact that modern-day financial firms are geographically unbounded and make their profits often by arbitraging the regulations of one country against another. Big financial firms have enormous legal departments to beat back regulators and ride as close to the law as possible.

There are other, harder-edged ideas floating around about what is needed to regulate sophisticated, globe-spanning firms. From the blogger Epicurean Dealmaker:

… I fleshed out my proposal by suggesting regulators get hired from Wall Street banks, big law firms, and elsewhere. An effective wholesale financial regulator should be comprised of forensic accountants, corporate and securities lawyers, investment bankers, derivative structurers, and the like. They should all be paid market rates for their services, which will make their compensation much, much closer to that of the people they regulate. They should be prohibited from accepting positions in private financial industry—and, most especially, at any individual firm they ever directly or indirectly regulated—or firms working for financial firms (law firms, accountancies, etc.) for a minimum of at least three years after they leave government service. Five would be preferable.

While individually expensive, I don’t believe you would need to hire many such people to make this kind of regulatory regime work. Given that you really only need high-powered regulators for the very biggest institutions, I am guessing you could get away with fewer than 100 to start. In fact, it might be less, because you really only need these people to direct and train their junior staff, and to interface directly with senior executives of the regulated entities. Fully loaded, I imagine you could fund a financial regulatory SWAT team like this for less than $150 million per year. That’s a drop in the bucket compared to the financial losses these supposedly regulated institutions have already inflicted on the American taxpayer, not to mention in comparison with the normal run rate of your average stodgy, inefficient, and ineffective government bureaucracy. Even better, you could fund such an agency with a levy indexed to the size of each financial institution under its jurisdiction. The larger and more complex a bank, the more fire-breathing, table-throwing, nail-spitting investment bankers and lawyers you could afford to throw at it. Talk about an incentive to shrink your balance sheet.

One of the most obvious ways to improve financial regulation is to combine the SEC and CFTC. As financial markets have grown more complex over the decades this idea has resurfaced over and over again. The premise is simple: two agencies with a long history of enforcement could leverage joint knowledge, data and technology. Instead, Dodd-Frank mandated that the agencies individually write rules then go through another process of consultation between them, even though many firms operate across regulatory lines. Even credit default swaps for municipal markets have elements that are overseen by both agencies.

You may wonder why Dodd-Frank, the largest overhaul of the securities laws since the Great Depression, did not merge these two regulators. The commonly-held view is that the four Congressional committees that oversee the two agencies would not give up their authority and subsequent donations from the financial sector. Given the near collapese of the financial system in 2008, I’m not sure that Congressmen wouldn’t given up their long-held fiefdoms if pushed. But no one pushed as Bloomberg reported in June 2009:

Lawmakers who attended a dinner with Treasury Secretary Timothy Geithner came away convinced he won’t push to merge the Securities and Exchange Commission and Commodity Futures Trading Commission, a proposal that already faces resistance on Capitol Hill, people briefed on the discussion said.

There are many lessons to be learned from the failure of MF Global. First and foremost financial firms cannot be relied on to self-police. Complex firms must have sophisticated, coordinated regulatory oversight. Congress really must increase the budgets of the SEC and CFTC, and if it really wanted to improve regulation, Congress should merge the SEC and CFTC. Every time a MF Global-type failure happens, investors lose confidence in the system.

I would disagree with the idea that regulators are not paid enough and that is why they do a bad job. The laws that they work with are written by the people they are regulating. The outcome of such a corrupt system is what we have today. Furthermore, the notion that the system is too “complex” and we need smarter people regulating is laughable. Credit default swaps are not complex. They are insurance policies and should be regulated as car or home insurance. The problem is clearly the entire legal system and the unabashed corruption in writing laws that restrict financial institutions’ activities then expecting an equally corrupt judicial and executive branch to do anything that changes the status quo.